“Best-case scenario” is a cliché used in many endeavors, from sports to politics to the weather forecast. Typically, it is a way to describe the most desirable outcome in any situation. The stock market these days seems to be reflecting near unanimity in a best-case scenario.
There are positive economic growth forecasts in virtually every developed and emerging economy. Energy and commodity prices, while having recovered from the bottom (remember when oil was $28 a barrel in January 2016?), are not threatening economic activity or a surge in inflation. Earnings estimates for large U.S. based corporations continue to be revised upward. The fiscal stimulus of a tax cut is only adding to the strong earnings estimates. Unemployment globally is declining. In the U.S. the rate has fallen from a peak of 10 percent in 2009 to 4.1 percent last month. Interest rates are still very low and home prices by some measures have regained much of the value lost in the great recession.
What could go wrong?
Things that go wrong fall into two major categories. There are the risks that derive naturally as an investor in unpredictable markets, and there are the behavioral aspects. How we respond to the current market euphoria or its inverse, market panic, can be as important as the actual market returns themselves.
Let’s consider some of the vulnerabilities in our best-case scenario. While the U.S. equity market’s upward trajectory provided great performance, much of the improvement has been concentrated in a few very large capitalization names. Just the five largest stocks in the Standard & Poor’s 500 Index contributed about a third of 2017’s results. Ironically, another weakness is the strength in the U.S. job market. The good news of low unemployment means there are fewer unemployed or underemployed people to respond to continued economic expansion. Lastly, the backdrop of geopolitical risks or financial system shocks is a constant threat to any rosy scenario. Crises are highly unpredictable and often of short duration, but not always. The 1987 stock market crash and the recent BREXIT vote were brief shocks to the system. The 1973 Arab oil embargo and the 2008 financial market meltdown lasted longer.
Realistically, we have no way of knowing what will precipitate the next market downturn or when it will occur. What we do know is that things can and do change. The quote attributed to the ancient Greek philosopher Heraclitus sums it up neatly: “Change is the only constant in life.”